Exposure Draft
Guidance Note on Accounting for Derivative
Contracts
(Last date of comments: January 21, 2015)
Issued by
Research Committee
The Institute of Chartered Accountants of India
(Set up by an Act of Parliament)
New Delhi
Exposure Draft
Guidance Note on Accounting for Derivative Contracts
Research Committee of the Institute of Chartered Accountants of India invites
comments on any aspect of this Exposure Draft of the `Guidance Note on Accounting
for Derivative Contracts'. Comments are most helpful if they indicate the specific
paragraph or group of paragraphs to which they relate, contain a clear rationale and,
where applicable, provide a suggestion for alternative wording.
Comments should be submitted in writing to the Secretary, Research Committee, The
Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100,
Indraprastha Marg, New Delhi 110 002, so as to be received not later than January
21, 2015. Comments can also be sent by e-mail at research@icai.in .
Introduction
1. In the year 2007, the Institute of Chartered Accountants of India (ICAI), issued
Accounting Standard (AS) 30, Financial Instruments: Recognition and Measurement and
Accounting Standard (AS) 31, Financial Instruments: Presentation. Both of these
Accounting Standards were to come into effect in respect of accounting periods
commencing on or after April 1, 2009 and were to be recommendatory in nature for an
initial period of two years. These were to become mandatory in respect of accounting
periods commencing on or after April 1, 2011. Further, it was clarified, that from the date
of AS 30 becoming recommendatory in nature, the following Guidance Notes on
Accounting, issued by the ICAI, stood withdrawn:
(i) Guidance Note on Guarantees & Counter Guarantees Given by the Companies
(ii) Guidance Note on Accounting for Investments in the Financial Statements of
Mutual Funds
(iii) Guidance Note on Accounting for Securitisation
(iv) Guidance Note on Accounting for Equity Index and Equity Stock Futures and
Options.
2. In March 2008, the ICAI issued an announcement that in case of derivatives, if an entity
does not follow AS 30, keeping in view the principle of prudence as enunciated in
Accounting Standard (AS) 1, Disclosure of Accounting Policies, the entity is required to
provide for losses in respect of all outstanding derivative contracts at the balance sheet
date by marking them to market. This announcement was applicable to financial
statements for the period ending March 31, 2008, or thereafter. In case of forward
contracts to which Accounting Standard (AS) 11, The Effects of Changes in Foreign
Exchange Rates (revised 2003) applies the entity needs to fully comply with the
requirements of AS 11.
3. Subsequently, in the year 2008, Accounting Standard (AS) 32, Financial Instruments:
Disclosures, was issued by the ICAI, which was also recommendatory initially and was
to become mandatory in respect of accounting periods commencing on or after April 1,
2011.
4. Owing to global financial crisis which raised issues regarding accounting treatment of
financial instruments, various accounting standards setting bodies including the ICAI
examined these aspects. Later, the ICAI withdrew the recommendatory as well as
mandatory status of AS 30, AS 31 and AS 32 in March 2011 by means of an
announcement. The announcement clarified that considering that International
Accounting Standard (IAS) 39, Financial Instruments: Recognition and Measurement,
issued by the International Accounting Standards Board (IASB), on which AS 30 is
based, was under revision by the IASB, AS 30 was not expected to be continued in its
present form, i.e., was expected to be revised. Further, the status of AS 30, AS 31 and AS
32 was clarified as below:
(i) To the extent of accounting treatments covered by any of the existing notified
accounting standards (e.g. AS 11, AS 13 etc.), the existing accounting standards would
continue to prevail over AS 30, AS 31 and AS 32.
(ii) In cases where a relevant regulatory authority has prescribed specific regulatory
requirements (e.g. Loan impairment, investment classification or accounting for
securitisations by the RBI, etc.), the prescribed regulatory requirements would
continue to prevail over AS 30, AS 31, AS 32.
(iii) The preparers of the financial statements are encouraged to follow the principles
enunciated in the accounting treatments contained in AS 30, AS 31 and AS 32 subject
to (i) and (ii) above.
5. Accordingly, currently, the relevant source of guidance for accounting of foreign
currency forward exchange contracts is AS 11, which is notified under the Companies
(Accounting Standards) Rules, 2006. AS 11 lays down accounting principles for foreign
currency transactions and foreign exchange forward contracts and in substance similar
contracts. However, it does not cover all types of foreign exchange forward contracts
since contracts used to hedge highly probable forecast transactions and firm
commitments are outside the scope of AS 11.
Objective
6. The objective of this Guidance Note is to provide guidance on recognition, measurement,
presentation and disclosure for derivative contracts so as to bring uniformity in their
accounting and presentation in the financial statements. This Guidance Note also
provides accounting treatment for such derivatives where the hedged item is covered
under notified Accounting Standards, e.g., a commodity, an investment, etc., because
except AS 11, no other notified Accounting Standard prescribes any accounting treatment
for derivative accounting. This Guidance Note, however, does not cover foreign
exchange forward contracts which are within the scope of AS 11. This Guidance Note is
an interim measure to provide recommendatory guidance on accounting for derivative
contracts and hedging activities considering the lack of mandatory guidance in this regard
with a view to bring about uniformity of practice in accounting for derivative contracts by
various entities.
Scope
7. This Guidance Note covers all derivative contracts that are not covered by an existing
notified Accounting Standard. Hence, it does not apply to the following:
(i) Foreign exchange forward contracts (or other financial instruments which in
substance are forward contracts covered) by AS 11.
(ii) Derivatives that are covered by regulations specific to a sector or specified set
of entities.
8. This Guidance Note will also be applicable to banking, non-banking finance companies
(`NBFCs') and insurance entities unless the guidance for accounting of derivative
contracts prescribed in this Guidance Note is in conflict with the accounting treatment
prescribed in the regulations issued by the concerned Regulators such as the Reserve
Bank of India (RBI) in case of banking entities including NBFCs and Insurance
Regulatory and Development Authority (IRDA) in case of insurance entities. In other
words the requirements of the Guidance Note will be applicable to entities carrying on
the business of banking including NBFCs and insurance to the extent it is not in conflict
with the requirements of the relevant regulations issued by RBI and IRDA respectively.
9. This Guidance Note also provides guidance on accounting of assets covered by
Accounting Standard (AS) 2, Valuation of Inventories, Accounting Standard (AS 10),
Accounting for Fixed Assets, Accounting Standard (AS), 13, Accounting for Investments,
etc., which are designated as hedged items, since such notified Accounting Standards are
silent on hedge accounting using derivative instrument for items covered by these
Standards. In contrast, AS 11 provides guidance specific to foreign currency forward
contracts. Accordingly, guidance for accounting for derivatives and hedging
relationships which pertain to hedged items covered under such notified Accounting
Standards, e.g., commodities stock, fixed assets, investments etc., is provided in this
Guidance Note. However, this Guidance Note does not provide guidance on accounting
for items and transactions covered in AS 11, which is a notified Standard. Similarly,
accounting for embedded derivative contracts is not part of the scope of this Guidance
Note since there are potential conflicts with the requirements of certain other notified
Accounting Standards such as AS 2, AS 13 etc.. Further, this Guidance Note does not
deal with macro-hedging and accounting for non-derivative financial assets/liabilities
which are designated as hedging instruments since its objective is to provide guidance on
accounting for derivative contracts only and not hedge accounting in its entirety.
10. This Guidance Note, thus, applies to following derivative contracts whether or not used
as hedging instrument:
(i) Foreign exchange forward contracts (or other financial instruments that are in
substance forward contracts) that are hedges of highly probable forecast
transactions and firm commitments (therefore outside the scope of AS 11);
(ii) Other foreign currency derivative contracts such as cross currency interest rate
swaps, foreign currency futures, options and swaps (not in the scope of AS
11);
(iii) Other derivative contracts such as traded equity index futures, traded equity
index options, traded stock futures and option contracts; and
(iv) Commodity derivative contracts;
This list is meant to be illustrative only and is not exhaustive.
11. Examples of contracts covered under the scope of the AS 11 and thus not covered
within the scope of this Guidance Note include;
· Foreign currency forward or future contract entered into to hedge the payment of a
monetary asset or a monetary liability recognised on balance sheet, e.g., a debtor,
creditor, loan, borrowing etc.
· A currency swap contract (principal only; no interest rate element) that hedges the
repayment of the principal of a foreign currency loan.
This list is meant to be illustrative only and is not exhaustive.
Definitions
12. For the purpose of this Guidance Note, the following terms are used with the meanings
specified as below:
Derivative: A derivative is a financial instrument or other contract with all three of the following
characteristics:
· its value changes in response to the change in a specified interest rate, financial
instrument price, commodity price, foreign exchange rate, index of prices or rates,
credit rating or credit index, or other variable, provided in the case of a non-financial
variable that the variable is not specific to a party to the contract (sometimes called
the "underlying")
· it requires no initial net investment or an initial investment that is smaller than would
be required for other types of contracts that would be expected to have a similar
response to changes in market factors; and
· it is settled at a future date.
Firm Commitment: A firm commitment is a binding agreement for the exchange of a specified
quantity of resources at a specified future date or dates.
Forecast transaction: A forecast transaction is an uncommitted but anticipated future
transaction.
Hedging Instrument: A hedging instrument is a designated derivative whose fair value or cash
flows are expected to offset changes in the fair value or cash flows, of a designated hedged item.
For the purposes of applying hedging in consolidated financial statements, the counterparty of a
derivative instrument needs to be outside the consolidated group.
Hedged Item: A hedged item is an asset, liability, firm commitment, highly probable forecast
transaction or net investment in a foreign operation that (a) exposes the entity to risk of changes
in fair value or future cash flows and (b) is designated as being hedged. A hedged item could
also be a portfolio or group of identified assets, liabilities, firm commitments, highly probable
forecast transactions or net investments in foreign operations.
Hedge Effectiveness: Hedge effectiveness is the degree to which changes in the fair value or
cash flows of the hedged item that are attributable to a hedged risk are offset by changes in the
fair value or cash flows of the hedging instrument.
Hedge Ratio: The ratio between the hedging instrument(s) and the hedged item(s) that is
maintained during the course of a hedging relationship.
The other terms which are used in the Guidance Note and are not defined above would be
deemed to have the same definitions as those contained in the Framework for Preparation and
Presentation of Financial Statements and Accounting Standards issued by the ICAI.
Key Accounting Principles
13. The accounting for derivatives covered by this Guidance Note is based on the following key
principles:
(i) All derivative contracts should be recognised on the balance sheet and
measured at fair value.
(ii) If any entity decides not to use Hedge Accounting as described in this
Guidance Note, it should account for its derivatives at fair value with changes
in fair value being recognised in the statement of profit and loss.
(iii) If an entity decides to apply Hedge Accounting as described in this Guidance
Note, it should be able to clearly identify its risk management objective, the
risk that it is hedging, how it will measure the derivative instrument if its risk
management objective is being met and document this adequately at the
inception of the hedge relationship and on an ongoing basis.
(iv) An entity may decide to use Hedge Accounting for certain derivative contracts
and for derivatives not included as part of Hedge Accounting, it will apply the
principles at (i) and (ii) above
(v) Adequate disclosures of accounting policies, risk management objectives and
hedging activities should be made in its financial statements.
Synthetic Accounting not permitted
14. This Guidance Note does not permit synthetic accounting, i.e., accounting of combining a
derivative and the underlying together as a single package. For instance, if any entity has a
foreign currency borrowing that it has hedged by entering into a cross currency interest rate
swap, it would require the entity to recognise the loan liability separately from the cross currency
interest rate swap and not treat them as a package (synthetic accounting) as INR loan.
Alternatively, if any entity has borrowed in terms of INR which it swaps with foreign currency
borrowing it would not treat such a loan as a foreign currency borrowing.
Recognition of derivatives on the balance sheet at fair value
15. This Guidance Note requires that all derivatives are recognised on the balance sheet and
measured at fair value since a derivative contract represents a contractual right or an obligation. .
16. Fair value in the context of derivative contracts represents the `exit price' i.e. the price that
would be paid to transfer a liability or the price that would be received when transferring an asset
to a knowledgeable, willing counterparty. The fair value would also incorporate, to the extent
relevant, the effect of credit risk associated with the fulfilment of future obligations. The extent
and availability of collateral should be factored in while arriving at the fair value of a derivative
contract.
Hedge Accounting
Designation of a derivative contract as a hedging instrument
17. An entity is permitted but not required to designate a derivative contract as a hedging
instrument. Where it designates a derivative contract as a hedging instrument, it needs to, as a
minimum:
(i) identify its risk management objective;
(ii) demonstrate how the derivative contract helps meet that risk management
objective;
(iii) specify how it plans to measure the derivative instrument if the derivative
contract is effective in meeting its risk management objective (including the
relevant hedge ratio);
(iv) document this assessment (of points (i), (ii), (v) (vi) and (vii) of this
paragraph) at inception of the hedging relationship and subsequently at every
reporting period;
(v) demonstrate in cases of hedging a future cash flow that the cash flows are
highly probable of occurring;
(vi) conclude that the risk that is being hedged could impact the statement of
profit and loss; and
(vii) adequately disclose its accounting policies, risk management objectives and
hedging activities (as required by this Guidance Note) in its financial
statements.
18. In India, for a large number of derivative contracts that are undertaken in the Over The
Counter (OTC) market, authorised dealers (generally banks) are required by the concerned
regulator (e.g. the Reserve Bank of India (RBI)) to determine whether all or some of the above
criteria are met before permitting an entity to enter into such a contract. The permissibility of a
contract under RBI regulations, whilst persuasive, is not a sufficient condition to assert that it
qualifies for hedge accounting under this Guidance Note. Certain derivative instruments that are
traded on stock exchanges such as foreign exchange futures contracts or equity options / equity
futures do not have such requirements and in those cases, in particular, it will be important to
demonstrate compliance with the above criteria before hedge accounting can be applied.
19. In case a derivative contract is not classified as a hedging instrument because it does not meet
the required criteria or an entity decides against such designation, it will be measured at fair
value and changes in fair value will be recognised immediately in the statement of profit and
loss.
20. It is clarified that derivatives cannot be designated for a partial term of the derivative
instrument. A derivative may be used in a hedging relationship relating to a portion of a non-
financial item as long as the hedged portion is clearly identifiable and capable of being measured
reliably.
Need for hedge accounting
21. Hedge accounting may be required due to accounting mismatches in:
· Measurement some financial instruments (non-derivative) are not measured at fair
value with changes being recognised in the statement of profit and loss whereas all
derivatives, which commonly are used as hedging instruments, are measured at fair
value.
· Recognition unsettled or forecast transactions that may be hedged are not
recognised on the balance sheet or are included in the statement of profit and loss
only in a future accounting period, whereas all derivatives are recognised at inception.
22. Example of measurement mismatches include the hedge of interest rate risk on fixed rate
debt instruments that are not held with the intention of trading. Another example of a
measurement mismatch could be a derivative undertaken to hedge the price risk associated with
recognised inventory.
23. Recognition mismatches include the hedge of a contracted or expected but not yet recognised
sale, purchase or financing transaction in a foreign currency and future committed variable
interest payments.
24. In order that the statement of profit and loss reflects the effect of the hedge properly, it is
necessary to match the recognition of gains and losses on the hedging instrument and those on
the hedged item. Matching can be achieved in principle by delaying the recording of certain
gains and losses on the hedging instrument or by accelerating the recording of certain gains and
losses on the hedged item in statement of profit and loss. Both of these techniques are used while
applying hedge accounting, depending on the nature of the hedging relationship.
Types of hedge accounting
25. This Guidance Note recognises the following three types of hedging;
· the fair value hedge accounting model is applied when hedging the risk of a fair value
change of assets and liabilities already recognised in the balance sheet, or a firm
commitment that is not yet recognised
· the cash flow hedge accounting model is applied when hedging the risk of changes in
highly probable future cash flows or a firm commitment in a foreign currency
· the hedge of a net investment in a foreign operation.
Fair value hedge accounting model
26. A fair value hedge seeks to offset the risk of changes in the fair value of an existing asset or
liability or an unrecognised firm commitment that may give rise to a gain or loss being
recognised in profit or loss. A fair value hedge is a hedge of the exposure to changes in fair value
of a recognised asset or liability or an unrecognised firm commitment, or an identified portion of
such an asset, liability or firm commitment, that is attributable to a particular risk and could
affect the statement of profit and loss.
27. When applying fair value hedge accounting, the hedging instrument is measured at fair value
with changes in fair value recognised in the statement of profit and loss. The hedged item is
remeasured to fair value in respect of the hedged risk even if normally it is measured at cost, e.g.,
a fixed rate borrowing. Any resulting adjustment to the carrying amount of the hedged item
related to the hedged risk is recognised in the statement of profit and loss even if normally such a
change may not be recognised, e.g., for inventory being hedged for fair value changes.
28. The fair value changes of the hedged item and the hedging instrument will offset and result in
no net impact in the statement of profit and loss except for the impact of ineffectiveness.
29. An example of a fair value hedge is the hedge of a fixed rate bond with an interest rate swap,
changing the interest rate from fixed to floating. Another example is the hedge of the changes in
value of inventory using commodity futures contracts.
30. The adjusted carrying amounts of the hedged assets in a fair value hedging relationship are
subject to impairment testing under other applicable Accounting Standards such as Accounting
Standard (AS) 28, Impairment of Assets, Accounting Standard (AS) 2, Valuation of Inventories,
Accounting Standard (AS) 13, Accounting for Investments etc
Cash flow hedge accounting model
31. A cash flow hedge seeks to offset certain risks of the variability of cash flows in respect of an
existing asset or liability or a highly probable forecast transaction that may be reflected in the
statement of profit and loss in a future period.
32. A cash flow hedge is a hedge of the exposure to variability in cash flows that (i) is
attributable to a particular risk associated with a recognised asset or liability (such as all or some
future interest payments on variable rate debt) or a highly probable forecast transaction or a firm
commitment in respect of foreign currency and (ii) could affect profit or loss. An example of a
cash flow hedge is the hedge of future highly probable sales in a foreign currency using a
forward exchange contract. Another example of a cash flow hedge is the use of a swap to change
the future floating interest payments on a recognised liability to fixed rate payments.
33. Under a cash flow hedge, the hedging instrument is measured at fair value, but any gain or
loss that is determined to be an effective hedge is recognised in equity, e.g., cash flow hedge
reserve. This is intended to avoid volatility in the statement of profit and loss in a period when
the gains and losses on the hedged item are not recognised therein.
34. In order to match the gains and losses of the hedged item and the hedging instrument in the
statement of profit and loss, the changes in fair value of the hedging instrument recognised in
equity must be recycled from equity and recognised in the statement of profit and loss at the
same time that the impact from the hedged item are recognised (recycled) in the statement of
profit and loss. The manner in which this is done depends on the nature of the hedged item:
· if the hedged forecast transaction results in a financial asset or a financial liability
being recognised, the gains or losses are recycled from equity as and when the asset
acquired or liability incurred affects the statement of profit and loss, e.g., when
interest income or expense is recognised.
· if the hedged forecast transaction results in a non-financial asset or non-financial
liability being recognised, either of the following two approaches may be applied:
the gains or losses are recycled from equity as and when the impact of asset
acquired or liability incurred affects or is recognised in the statement of profit and
loss, e.g., as depreciation or cost of sales is recognised.
the gains or losses are recycled from equity and included as a separate adjustment
that is clubbed for financial statement presentation purposes with carrying amount
of the asset acquired or liability incurred (referred to as the "basis adjustment")
· in all other cases the gains or losses are recycled from equity as and when the hedged
forecast transaction affects statement of profit and loss.
Note that in the first two bullets above, any gain or loss (or portions thereof) that is
not expected to be recovered in future periods are recycled from equity as soon as an
entity becomes aware of the fact that those amounts are not expected to be recovered.
35. An example of a forecast transaction that results in the recognition of a financial liability is a
forecast issuance of a bond, which is hedged for interest rate risk using a forward-starting interest
rate swap. The fair value gains or losses on the swap would be deferred in equity until the bond
is issued and the swap starts, after which date they would remain in equity until amortised into
statement of profit and loss over the life of the bond.
36. The choice of the basis adjustment approach is only relevant for hedges of forecast purchases
of non-financial assets such as inventory or property, plant and equipment. This approach is
permitted but not required and must be applied consistently as an accounting policy choice to all
cash flow hedges that result in the acquisition of a non-financial asset or non-financial liability.
Any basis adjustment or accumulated balance in the hedging reserve will require to be tested at
least at every reporting date for impairment. For the purposes of this impairment assessment, the
basis adjustment / relevant portion of the hedging reserve may be combined with the carrying
amount of the hedged item and compared to its current realisable .
Net investment hedging
37. An investor in a foreign operation is exposed to changes in the carrying amount of the net
assets of the foreign operation (the net investment) arising from the translation of those assets
into the reporting currency of the investor.
38. Principles relating to the hedge of a net investment in a foreign operation are:
· foreign exchange gains and losses on a net investment in a foreign operation are
recognised directly in equity. This occurs through the translation of the foreign
operation's net assets for purposes of consolidation;
· gains and losses on foreign currency derivatives used as hedging instruments are
recognised directly in equity to the extent that the hedge is considered to be effective;
· the ineffective portion of the gains and losses on the hedging instruments (and any
proportion not designated in the hedging relationship) is recognised in the statement
of profit and loss immediately;
· any net deferred foreign currency gains and losses, i.e., arising from both the net
investment and the hedging instruments are recognised in the statement of profit and
loss at the time of disposal of the foreign operation.
39. This Guidance Note does not override the principles of AS 11. However, it introduces the
hedge accounting criteria for hedging of net investments.
40. When the net investment is disposed off, the cumulative amount in the foreign currency
translation reserve in equity is transferred to the statement of profit and loss as an adjustment to
the profit or loss on disposal of the investment. Therefore, it is necessary for an entity to keep
track of the amount recognised directly in equity separately in respect of each foreign operation,
in order to identify the amounts to be transferred to the statement of profit and loss on disposal.
Formal documentation at inception
41. At inception of a hedge, formal documentation of the hedge relationship must be established.
The hedge documentation prepared at inception of the hedge must include a description of the
following:
· the entity's risk management objective and strategy for undertaking the hedge;
· the nature of the risk being hedged;
· clear identification of the hedged item (asset, liability or cash flows) and the hedging
instrument;
· demonstrate how the derivative contract helps meet that risk management objective;
· identity how it plans to measure the derivative if the derivative contract is effective in
meeting its risk management objective;
· demonstrate in cases of hedging a future cash flow that the cash flows are highly
probable of occurring; and
· conclude that the risk that is being hedged could impact the statement of profit and
loss.
42. This Guidance Note does not mandate a specific format for the documentation and in practice
hedge documentation may vary in terms of lay-out, technology used etc. Various formats may be
acceptable as long as the documentation includes the contents identified above.
43. A hedging relationship is effective if it meets all of the following requirements:
(i) There is an economic relationship between the hedged item and the hedging
instrument.
(ii) The effect of credit risk does not dominate the value changes that result from that
economic relationship.
(iii) The hedging relationship is expected to be highly effective in achieving the stated risk
management objective and the entity is in a position to reliably measure the
achievement of this objective both a inception and on an ongoing basis during the
tenure of the hedging relationship.
Hedge effectiveness testing and measurement of ineffectiveness
44. This Guidance Note does not prescribe one single method for how hedge effectiveness
testing and ineffectiveness measurement should be conducted. The appropriate method for each
entity will depend on the facts and circumstances relevant to each hedging programme and be
driven by the risk management objective of the entity.
45.Hedge effectiveness is the extent to which changes in the fair value or the cash flows of the
hedging instrument offset changes in the fair value or the cash flows of the hedged item (for
example, when the hedged item is a risk component, the relevant change in fair value or cash
flows of an item is the one that is attributable to the hedged risk). Hedge ineffectiveness is the
extent to which the changes in the fair value or the cash flows of the hedging instrument are
greater or less than those on the hedged item.
46.When designating a hedging relationship, and on an ongoing basis, an entity will analyse the
sources of hedge ineffectiveness that are expected to affect the hedging relationship during its
term. This analysis will serve as the basis for the entity's assessment of meeting the hedge
effectiveness requirements.
47.A hedging relationship will meet the hedge effectiveness requirements if:
(i) there is an economic relationship between the hedged item and the hedging instrument
(ii) the effect of credit risk does not dominate the value changes that result from the
economic relationship
(iii)the hedge ratio of the hedging relationship is the same as that resulting from the
quantities of:
- the hedged item that the entity actually hedges; and
- the hedging instrument that the entity actually uses to hedge that quantity of hedged item;
and
(iv) the hedged item and the hedging instrument are not intentionally weighted to create
hedge ineffectiveness - whether or not it is recognised - to achieve an accounting
outcome that would be inconsistent with the purpose of hedge accounting.
48.An entity will assess at the inception of the hedging relationship, and on an ongoing basis,
whether a hedging relationship meets the hedge effectiveness requirements. At a minimum, an
entity should perform the ongoing assessment at each reporting date or upon a significant change
in the circumstances affecting the hedge effectiveness requirements, whichever comes first. The
assessment relates to expectations about hedge effectiveness and is therefore only forward-
looking.
49.If the critical terms of the hedging instrument and the hedged item - e.g. the nominal amount,
maturity and underlying - match or are closely aligned, then it may be possible to use a
qualitative methodology to determine that an economic relationship exists between the hedged
item and the hedging instrument.
50. If a hedging relationship ceases to meet the hedge effectiveness requirement relating to the
hedge ratio but the risk management objective for that designated hedging relationship remains
the same, an entity should adjust the hedge ratio of the hedging relationship so that it meets the
qualifying criteria again.
51. This Guidance Note does not also prescribe a single method of how ineffectiveness
measurement should be conducted other than to require an entity to consider how ineffectiveness
could affect a hedging relationship and require immediate recognition of such ineffectiveness.
52.Hedge ineffectiveness is measured based on the actual performance of the hedging instrument
and the hedged item, by comparing the changes in their values in currency unit amounts.
53.When measuring hedge ineffectiveness, an entity is required to consider the time value of
money. Consequently, the entity determines the value of the hedged item on a present value basis
and therefore the change in the value of the hedged item also includes the effect of the time value
of money.
54. In certain situations, ineffectiveness is required to be recognised. These include
· in a cash flow hedge, when the forecasted hedged transaction is no longer probable of
occurring;
· in a fair value hedge, when the hedging instrument is no longer considered to be an
effective hedge of the hedging instrument; and
· in any hedge relationship, if the risk management objective is changed or no longer
expected to be met.
Termination of hedge accounting / reclassification of hedge reserves
55. An entity is not permitted to stop applying hedge accounting voluntarily unless the risk
management objective of the entity, as was originally defined by the entity when first applying
hedge accounting, is no longer met.
56. If an entity terminates a hedging instrument prior to its maturity / contractual term, hedge
accounting is discontinued prospectively. Any amount previously recognised in the hedge
reserve (in the case of cash flow or net investment hedges) is reclassified into the statement of
profit and loss only in the period when the hedged item impacts earnings, e.g., when a forecasted
purchase / sale actually impacts earnings or when a net investment is disposed off in the case of a
net investment hedge.
57. In case of hedges of highly probable forecast transactions or commitments, if the forecasted
transaction is no longer highly probable of occurring, (but still probable of occurring) then hedge
accounting is discontinued prospectively but the amount recognised previously in the hedge
reserve is reclassified into the statement of profit and loss only in the period when the hedged
item impacts earnings (as specified in paragraph 34 of this Guidance Note). Probable for the
purpose of this assessment is based on whether the forecasted is `more likely than not' (or greater
than 50% probability) of occurring .
58. In case of hedges of forecast transactions, if the forecasted transaction is no longer probable
of occurring, then hedge accounting is discontinued and all amounts recognised in the hedge
reserve are recognised immediately in the statement of profit and loss. Probable for the purpose
of this assessment is based on whether the forecasted is `more likely than not' (or greater than
50% probability) of occurring.
Presentation in the financial statements
59. Derivative assets and liabilities recognised on the balance sheet at fair value should be
presented as current and non-current based on the following considerations:
· Derivatives that are intended for trading or speculative purposes should be reflected
as current assets and liabilities.
· Derivatives that are hedges of recognised assets or liabilities should be classified as
current or non-current based on the classification of the hedged item.
· Derivatives that are hedges of forecasted transactions and firm commitments should
classified as current or non-current based on the settlement date / maturity dates of
the derivative contracts.
· Derivatives that have periodic or multiple settlements such as interest rate swaps
should not be bi-furcated into current and non-current elements. Their classification
should be based on when a predominant portion of their cash flows are due for
settlement as per their contractual terms.
60. This Guidance Note does not permit any netting off of assets and liabilities except where
basis adjustment is applied under cash flow hedges and hence all the amounts presented in the
financial statements should be gross amounts. Amounts recognised in the income statement for
derivatives not designated as hedges may be presented on a net basis.
Disclosures in financial statements
61. An entity should satisfy the broader disclosure requirements by describing its overall
financial risk management objectives, including its approach towards managing financial risks.
Disclosures should explain what the financial risks are, how the entity manages the risk and why
the entity enters into various derivative contracts to hedge the risks.
62. The entity should disclose its risk management policies. This would include the hedging
strategies used to mitigate financial risks. This may include a discussion of:
· how specific financial risks are identified, monitored and measured;
· what specific types of hedging instruments are entered into and how these instruments
modify or eliminate risk; and
· details of the extent of transactions that are hedged.
63. An entity is also required to make specific disclosures about its outstanding hedge accounting
relationships. The following disclosures are made separately for fair value hedges, cash flow
hedges and hedges of net investments in foreign operations:
· a description of the hedge;
· a description of the financial instruments designated as hedging instruments for the
hedge and their fair values at the balance sheet date;
· the nature of the risks being hedged;
· for hedges of forecast transactions, the periods in which the transactions are expected
to occur, when they are expected to affect the statement of profit and loss, and a
description of any forecast transactions that were originally hedged but now are no
longer expected to occur. This Guidance Note does not specify the future time bands
for which the disclosures should be made. Entities should decide on appropriate
groupings based on the characteristics of the forecast transactions;
· if a gain or loss on derivative or non-derivative financial assets and liabilities
designated as hedging instruments in cash flow hedges has been directly recognised
in the hedging reserve: -
- the amount recognised in hedge reserve during the period.
- the amount recycled from the hedge reserve and reported in statement of profit
and loss.
- the amount recycled from hedge reserve and added to the initial measurement of
the acquisition cost or other carrying amount of a non-financial asset or non-
financial liability in a hedged forecast transaction.
· a breakup of the balance in the hedge reserve between realised and unrealised
components and a reconciliation of the opening balance to the closing balance for
each reporting period.
64. Appendix contains examples illustrating the principles contained in this Guidance Note
Transitional provisions
65. This Guidance Note applies to all derivative contracts covered by it and are outstanding on
the date this Guidance Note becomes effective. Any cumulative impact (net of taxes) should be
recognised in reserves as a transition adjustment and disclosed separately. An entity is not
permitted to follow hedge accounting as recommended in this Guidance Note retrospectively.
Effective Date
66. This Guidance Note comes into effect in respect of accounting periods beginning on or after
1st April, 2015. From the date this Guidance Note comes into effect the following
Announcements issued by the Council of the ICAI stand withdrawn:
(i) Applicability of Accounting Standard (AS) 11 (revised 2003), The Effects of Changes in
Foreign Exchange Rates, in respect of exchange differences arising on a forward exchange
contract entered into to hedge the foreign currency risk of a firm commitment or a highly
probable forecast transaction issued on the basis of the decision of the Council at its meeting held
on June 24-26, 2004
(ii) Disclosures regarding Derivative Instruments published in `The Chartered Accountant",
December 2005 (pp 927)
(iii). Accounting for Derivatives published in `The Chartered Accountant", May 2008 (pp.1945)
(iv) Application of AS 30, Financial Instruments: Recognition and Measurement published in
`The Chartered Accountant', April 2011 (pp. 1575) to the extent of the guidance covered for
accounting for derivatives within the scope of this Guidance Note.
Appendix
Illustrative examples of application of Guidance Note
1. Application of Cash Flow Hedge
ABC Ltd. is an exporter of goods. In the month of July 2013, it receives the order for supply of goods to
US customers in the month of January 2014 and as per the Payment cycle with the customers, it expects
to realise 1 LakhUSD in April 2014.
ABC Ltd has decided to fully hedge the receivables from foreign currency risk of the sale receivables.
Immediately after getting the order, to hedge the highly probable Foreign currency receivables, it enters
into a derivative transaction with XYZ Bank, for future sale of 1 Lakh USD in the month of April 2014
@ Rs. 65 per USD (Spot Rate was Rs. 64.50 per USD).
For this purpose, it is assumed that the company has entered into a cash flow hedge, which is generally
the case for hedging foreign currency risk.
Further it is assumed that:
· At the time of booking of sale in January 2014, the USD rate was Rs. 61, and forward rate for
delivery on April 30, 2014 was Rs 61.20.
· On the reporting date on March 31, 2014, the USD rate was Rs. 60.50, and forward rate for
delivery on April 30, 2014 was Rs 60.60.
· At the time of realisation USD rate was Rs. 60/- on April 30, 2014.
The above transaction shall be accounted in the following manner.
July 01, 2013 ABC Limited entered to sell a forward exchange
contract for USD 1,00,000 having ten months maturity
on April 30, 2014
Forward Exchange Rate 65.00
Spot Rate as at July 01, 2014 64.50
No entry in the books
Upto January
31, 2014 ABC Limited accounts the MTM effect in the books
Forward Contract Rate Entered 65.00
Forward Contract Available in the Market with similar
maturity 61.20
Entry
Forward contract Receivable 3,80,000
To Cash Flow Hedge Reserve 3,80,000
January 31, ABC Limited recognises the revenue by booking an
2014 invoice for USD 1 Lakh, having credit period of 90
Days (i.e. Due Date - April 30, 2014)
Spot Rate as at January 31, 2014 61.00
Forward Contract Available in the Market with similar
maturity 61.20
Recognition of Revenue
Accounts Receivable 61,00,000
To Revenue 61,00,000
Recognition of Hedging gain
Cash Flow Hedge Reserve 3,80,000
To Statement of Profit and loss 3,80,000
March 31,
2014 Spot Rate 60.50
Forward Contract Available in the Market with similar
maturity 60.60
Restatement of Accounts Receivable
Forex Gain/Loss (P&L) 50,000
To Accounts Receivable 50,000
MTM Effect of Forward Cover
Forward contract Receivable 60,000
To Forex Gain/Loss (P&L) 60,000
April 30, 2014 Spot rate 60.00
Realisation of Accounts Receivable
Bank 60,00,000
Forex Gain/Loss (P&L) 50,000
To Accounts Receivable 60,50,000
Maturity of Forward Contract
Bank 5,00,000
To Forward contract Receivable 4,40,000
To Forex Gain/Loss (P&L) 60,000
2. Cash flow hedge of the repayment of a loan
Company X is an Indian company with annual reporting period ending on March 31 each year.
On January 1, 2014, Company X borrows from a bank USD 1 million six month debt carrying a
floating interest rate of three month LIBOR plus 50 basis points. As per the Company's risk
management policies, it enters into a Cross Currency Interest Rate Swap (CCIRS) with a bank to
swap the above floating interest bearing USD debt into a fixed interest bearing INR debt.
Since the CCIRS does not fall within the scope of AS 11 and has been entered into to hedge the
exposure of currency and interest rate risk arising from the debt instrument, it would be within
the scope of this Guidance Note.
According to this Guidance Note, Company X will record the following on March 31, 2014:
(i) Translate the USD loan at closing rate and record the foreign exchange gain/ loss
in the statement of profit and loss.
(ii) Record a derivative asset/ liability based on the fair value (Mark To Market
`MTM' value) of the CCIRS with a corresponding credit/debit in Cash Flow
Hedging Reserve.
(iii) Record the net interest expense in statement of profit and loss, i.e., the USD
floating interest expense adjusted for the settlement of the interest rate swap for
the period.
(iv) Reclassify from the Cash Flow Hedging Reserve to statement of profit and loss
the amount by which the hedged item, i.e., the debt has impacted the statement of
profit and loss. (In this case, the amount of translation foreign exchange gain/ loss
that has been recorded for the loan)
As at March 31, 2014, the Balance Sheet of Company X will carry the following items:
· Loan Translated at the closing USD INR conversion rate
· Derivative asset/ liability MTM of the CCIRS
· Cash flow Hedging Reserve - MTM of the CCIRS less amount reclassified to the
statement of profit and loss.
3a. Commodity contract cash flow hedge of a forecasted sale with an exchange traded
future
Company Z is a producer and wholesaler of copper with annual reporting period ending on
March 31 each year. On January 1, 2014, Company Z forecasts sales of 100 tonnes of copper
expected to occur in September 2014. It is highly probable that the sales will occur based on
historical and expected sales. In order to hedge its exposure on the variability of copper prices,
Company Z enters into a `sell' futures contract on the Commodity Exchange to sell 100 tonnes of
copper (same grade) with maturity of September 30, 2014. As per its risk management policies,
Company Z designates this futures contract as a cash flow hedge of highly probable forecasted
sales of 100 tonnes of copper inventory in September 2014.
Since the commodity future does not fall within the scope of AS 11 and has been entered into to
hedge the exposure of variability in cash flows arising from price risk, this would fall within the
scope of this Guidance Note.
According to this Guidance Note, Company Z will record the following on March 31, 2014
Record a derivative asset/ liability based on the fair value (MTM) of the commodity
future contract with a corresponding credit/ debit to Cash Flow Hedging Reserve.
As at March 31, 2014, the Balance Sheet of Company Z will carry the following items:
· Derivative asset/ liability MTM of the commodity future contract
· Cash flow Hedging Reserve - MTM of the commodity future contract
Assuming that the sales in future occur as expected, the MTM carried in the Cash flow Hedging
Reserve will be reclassified to the statement of profit and loss when the sales are booked in the
statement of profit and loss. In this case, this will happen in September 2014 along with the
maturity of the commodity futures contract. Such reclassification can be made in the sales line
item in the Profit and Loss account, which potentially records the sales at the hedged price.
3b. Commodity contract fair value hedge of forecasted sales with an exchange traded
future
Continuing the above example, consider that Company Z designates the commodity futures
contract as a fair value hedge of a portion of its inventory, i.e., 100 tonnes of copper. The
Company documents it as a hedge of the exposure to changes in fair value of the inventory due
to commodity price risk. As at March 31, 2014, the price of copper increases thereby resulting in
an increase in the fair value of inventory and MTM loss on the derivative.
Since the commodity future does not fall within the scope of AS 11 and has been entered into to
hedge the exposure of variability in fair values due to price risk, it would fall within the scope of
this Guidance Note.
According to this Guidance Note, Company Z will record the following on March 31, 2014:
(i) Record a derivative liability based on the fair value (MTM) of the commodity
future contract with a corresponding debit to the statement of profit and loss.
(ii) Record an increase in inventories for the change in fair value as a hedge
accounting adjustment through statement of profit and loss. Accounting Standard
(AS) 2, Valuation of Inventories, requires inventories to be carried at the lower of
cost or net realisable value. Hence, this will be recorded as a separate hedge
accounting adjustment distinguished from the valuation of inventories under AS 2.
As at March 31, 2014, the Balance Sheet of Company Z will carry the following items:
· Derivative asset/ liability MTM of the commodity future contract
· Inventory valued as per AS 2 at cost
· Inventory hedge accounting adjustment basis adjustment to record change in fair value
When sales of the hedged inventory occur in the future, the hedging related fair value adjustment
to inventory will be released to the statement of profit and loss and can be classified as part of
`cost of goods sold'.
4. Hedging a portion of a non-financial item Commodity future
Company X is a producer and wholesaler of steel with annual reporting period ending on March
31 each year. On January 1, 2014, Company X forecasts sales of 200 tonnes of steel expected to
occur in September 2014. It is highly probable that the sales will occur based on historical and
expected sales. In order to hedge its exposure on the variability of expected cash flows from
forecasted sales of steel, as per its risk management policies, Company X enters into a `sell'
futures contract on the commodity exchange for 200 tonnes of iron ore which is one of the
significant components of the steel making process and significantly impacts the price of steel.
Since the commodity future does not fall within the scope of AS 11 and has been entered into to
hedge the exposure of variability in cash flows arising from price risk, this would fall under the
scope of this Guidance Note. This will not result into a perfect hedge since the hedged
commodity, i.e., steel and the hedging instrument used, i.e., iron ore futures, are not perfectly
correlated. The Guidance Note permits such designation if it is as per the company's risk
management policies and strategy.
According to this Guidance Note, Company X will record the following on March 31, 2014:
Record a derivative asset/ liability based on the fair value (MTM) of the iron ore future
contract with a corresponding credit/ debit to Cash Flow Hedging Reserve.
As at March 31, 2014, the Balance Sheet of Company X will carry the following items:
· Derivative asset/ liability MTM of the iron ore future contract
· Cash flow Hedging Reserve - MTM of the iron ore future contract
Assuming that the sales in future occur as expected, the MTM carried in the Cash flow Hedging
Reserve will be reclassified to the statement of profit and loss when the sales are booked in the
statement of profit and loss. In this case, this will happen in September 2014 along with the
maturity of the commodity futures contract. Such reclassification can be made in the sales line
item in the Profit and Loss account.
5. Exchange traded contract Fair value hedge of investment portfolio
Company Z holds a closed portfolio of equity shares classified as current investments under AS
13. As per its risk management policies, Company Z hedges its exposure to variability of
expected fair value of the investments by entering into equity futures contract on a recognized
stock exchange.
Since this derivative is outside the scope of AS 11 and is entered into to hedge a specific
exposure, this would fall within the scope of this Guidance Note.
Under this Guidance Note, Company Z will record the following on March 31, 2014:
(i) Record a derivative liability / derivative asset based on the fair value (MTM) of
the equity futures contract with a corresponding debit to the statement of profit
and loss.
(ii) Record an increase / decrease in current investments for the change in fair value as
a hedge accounting adjustment through statement of profit and loss. Accounting
Standard (AS) 13, Valuation of Investments, requires long term investments to be
carried at lower of cost or fair value. Hence this will be recorded as a separate
hedge accounting adjustment distinguished from the valuation of investments
under AS 13.
As at March 31, 2014, the Balance Sheet of Company Z will carry the following items:
· Derivative asset/ liability MTM of the equity futures contract
· Long term investments valued as per AS 13 at cost
· Investment hedge accounting adjustment adjustment to record change in fair value
6. Cash flow hedge accounting forecasted sale with a forward contract
Company X is an Indian Company with annual reporting period ending on March 31 each year.
On January 1, 2014, Company X forecasts sales of USD 1 million on September 30, 2014. It is
highly probable that the sales will occur based on historical and expected sales. As per its risk
management policies, in order to hedge the variability in cash flows arising from future sales in
foreign currency, on January 1, 2014, Company X enters in to a sell USD buy INR forward
contract which matures on September 30, 2014.
Since the forward contract is taken to hedge highly probable forecasted sales transactions, it does
not fall within the scope of AS 11 and hence is within the scope of this Guidance Note.
According to this Guidance Note, Company X will record the following on March 31, 2014:
Record a derivative asset/ liability based on the fair value (MTM) of the foreign currency
forward contract with a corresponding credit/ debit to Cash Flow Hedging Reserve.
As at March 31, 2014, the Balance Sheet of Company X will carry the following items:
· Derivative asset/ liability MTM of the foreign currency forward contract
· Cash flow Hedging Reserve - MTM of the foreign currency forward contract
Assuming that the sales in future occur as expected, the MTM carried in the Cash flow Hedging
Reserve will be reclassified to the statement of profit and loss when the sales are booked in the
statement of profit and loss. In this case, this will happen in September 30, 2014 along with the
maturity of the foreign currency forward contract. Such reclassification can be made in the sales
line item in the statement of profit and loss, which records the sales at the hedged rate.
7. Cash flow hedge accounting - forecasted sale with an option contract
Company X is an Indian Company with annual reporting period ending on March 31 each year.
On January 1, 2014, Company X forecasts sales of USD 1 million on September 30, 2014. It is
highly probable that the sales will occur based on historical and expected sales. As per its risk
management policies, in order to hedge the variability in cash flows arising from future sales in
foreign currency, on January 1, 2014 Company X enters in to a sell USD buy INR option
contract which matures on September 30, 2014.
Since the option contract is taken to hedge highly probable forecasted sales transactions, it does
not fall within the scope of AS 11 and hence is within the scope of this Guidance Note.
According to this Guidance Note, Company X will record the following:
On January 1, 2014 - Record an option asset on payment of option premium
On March 31, 2014 - Record changes in fair value of the option asset based on the MTM of the
foreign currency option contract with a corresponding credit/ debit to Cash Flow Hedging
Reserve.
As at March 31, 2014, the Balance Sheet of Company X will carry the following items:
· Derivative asset/ liability MTM of the foreign currency option contract
· Cash flow Hedging Reserve - MTM of the foreign currency forward contract
Assuming that the sales in future occur as expected, the MTM carried in the Cash flow Hedging
Reserve will be reclassified to the statement of profit and loss when the sales are booked in the
statement of profit and loss. In this case, this will happen on September 30, 2014, along with the
maturity of the foreign currency option contract. Such reclassification can be made in the sales
line item in the statement of profit and loss account, which records the sales at the hedged rate.
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